by Bill Barclay
Petroleum and its products, from gasoline to bunker fuel to makeup, is the most valuable good in world trade. Oil provides almost one-third of world energy supplies,1 is the primary business for four of the 16 largest companies in the world (eclipsed only by the finance sectors’ seven) and is the most actively traded commodity futures contract in the world.2 And this year oil seems to be the driving force behind financial market volatility: the correlation between the S&P 500 and oil prices is over .75 year-to-date.
This correlation between oil prices and the U.S. stock market is unusual. So, what is happening — and what does it mean for the future?
There are three new factors in the political economy of oil that are reshaping the economics and the politics of petroleum and petroleum products.
First, there is the emergence of the U.S. as the swing producer, a role occupied by Saudi Arabia for the last several decades. This is the result of a 2004 to 2014 expansion in the production of light tight oil (LTO), the product of fracking.
Second, is the decision by OPEC, primarily driven by Saudi Arabia, not to reduce production in response to the collapse of prices from $115/barrel less than two years ago to around $30/barrel today. This decision results from the Saudi experience in losing market share to other OPEC exporters during previous agreements to freeze or reduce production.
Third, the slowing of economic growth in the largest petroleum importing economy, China, means that market shares lost will be harder to regain. Total Saudi crude exports and Chinese crude imports are roughly equal, although, of course, not all Saudi exports go to China.3
It may be useful to start an analysis by speculating on the Saudi strategy in the new oil political economy. While the strategy may not be completely clear, there are at least two significant factors that must be entering their calculations. On the one hand, as the low-cost producer at less than $11/barrel, the kingdom can be profitable even at current price levels. Likely of more importance, the kingdom does not want to surrender market share to another low-cost producer, Iran, the fifth largest producer and a political-religious opponent because of different geopolitical interests and versions of Islam. In addition, Iran also has the largest fleet of very large crude carriers (VLCC), giving them a potential competitive advantage.
The second significant change facing the Saudis, the shift of the U.S. from a net deficit petroleum country to a net surplus — and thus a potential competitor for market share — is probably the most significant change in the equation of the political economy of oil. This shift is particularly important because light tight oil production is likely to be more price elastic than traditional OPEC and Russian production. LTO extraction has a shorter lead time and can also be shuddered more quickly than traditional oil extraction methods, giving U.S. LTO producers an advantage in responding to shifts in demand and price.
The demand shift that has been the biggest focus of media discussion is the slowing of Chinese economic growth. This is certainly a factor in the collapse of crude prices but, probably of equal importance, is beginning shift in the oil intensity of Chinese economic growth, a process that has been underway in Western Europe and the U.S. for at least three decades. In short, the internal Saudi model of petro-capitalism is facing increasing constraints at the same time that additional competitors are entering the market.4 They will also have less money to finance institutions promoting their Salafi version of Islam in the rest of the Middle East.
In the U.S. the decade-long boom in fracking is over, although this doesn’t mean that LTO production cannot return relatively easily. However, at current price levels much of the new production — and a lot of established producers — are not profitable. Of course, when an asset-price bubble begins to burst, it is always interesting to ask about the banks that, inevitably, were drawn into the financing of the bubble. In the 2004-2014 decade, there was an eleven-fold increase in junk-bond energy debt, much of it held by oil-patch banks but also by the big names such as Goldman Sachs, J. P. Morgan-Chase and Morgan Stanley. In the opening months of 2016, many of these banks have announced an increase in their net loan loss reserves against “troubled” energy-sector debt while at the same time insisting that everything is under control and that they are not in financial trouble as ongoing institutions. The stock market has not taken these announcements favorably, and it is the finance sector that has suffered the biggest hit in prices during the opening weeks of trading in 2016. And market participants obviously get the connection: When oil prices take a hit, financial stocks follow. Oil-patch bankruptcy filings totaled 42 in 2015, with the pace accelerating in the final months of year.
To date is it probably accurate to say that the threat of defaults by energy companies does not pose the risk that the housing bubble did. We’re talking about a few $100 billion rather than a few trillion. However, the interconnections of Mideast oil, slowing Chinese growth and financial risk taking can spiral out of control with a much larger impact than any one variable suggests. As the Chinese say, “May you live in interesting times.”
1 Down from over 45% in 1973 with much of the decline coming from a gain in coal. LNG has also grown market share but 6 of the top 10 petroleum producers are also in the top 10 LNG producers.
2 The Koch brothers made most of their huge fortunes trading, rather than producing or refining, petroleum.
3 China, however, is Saudi Arabia’s largest market.
4 The kingdom has increased the price of gasoline by 50% to about $0.90/gal and young Saudis are finding diminished government job prospects (the public sector accounts for about 80 % of Saudi citizen jobs).